Today I will make a few points about liquidity. I have spoken about this on
a number of other occasions, but one year out from the Basel III liquidity
regime becoming fully operational, it is timely to do so again.[1]

Why do we have liquidity regulation?

The fundamental answer is that banks engage in maturity transformation. They
borrow short and lend long. This is a service which society values.

There is a demand for banks to provide liquidity services. Depositors place
their savings with a bank but want to be able to withdraw some part of their
funds at short notice. A corporate treasurer wants to have the company's
funds in an account where they can be accessed quickly to meet the needs of
the firm.

At the same time, we prefer to have our loans for substantially longer periods
of time. It would be particularly inefficient and bothersome if we had to renegotiate
our home loan on a monthly basis. More importantly, it would be very difficult
to make any sort of long-term planning or investment decision if there were
no long-term loans available.

This desire for liquidity on the one hand and long-term lending on the other
is intermediated by the financial sector and the banking sector in particular.
But the maturity transformation this entails exposes the banking sector to
liquidity risk. If all the depositors wanted their money back in a hurry, the
bank would not be able to meet that obligation without either calling in their
loans, which may be contractually impossible, or trying to sell them. The latter
is often practically impossible to do at short notice, or even if it is possible,
may only be able to be carried out by selling the assets (such as loan portfolios)
at fire-sale prices. Neither of those outcomes is socially desirable.

Fire sales run the risk of generating contagion to other financial institutions
as the price of the asset falls, as they may well hold that same asset too,
and/or may use it as collateral in transactions themselves. Fire sales also
limit the ability of the institution making the sale to make good on its obligations.
So there are externalities to the asset that is being sold, as well as to the
financial system as a whole.

Liquidity regulation addresses this issue by ensuring that the banking system
has some level of liquidity at hand to meet predictable liquidity demands.
In the case of Basel III, banks need to have available sufficient liquidity
to meet a 30-day stress scenario. In simple terms, a bank must have enough
liquid assets that can be easily liquefied (not at fire-sale prices) to meet
any of its liabilities that fall due within that 30-day period. In Basel III,
these assets are labelled high-quality liquid assets (HQLA).

This implies that more liquid liabilities, those with less than 30 days to maturity,
will be more costly for the bank to provide. Hence, one would expect to see
an increase in the cost to the customer of obtaining that liquidity service.
We have seen this start to occur in Australia as the implementation date of
Basel III, 1 January 2015, comes into sight. But my sense is that
there is more of this repricing still to come. As I have said before, the rate
of return available on at-call accounts does not seem to sufficiently reflect
the cost to the bank of providing such liquidity. Maybe we will have to wait
for 31 December 2014 for this to occur, as there is potentially a
large first-mover disadvantage from being the first to reprice the product.
The lower interest rate is likely to see customers move rapidly to a competitor
who has yet to reprice. In the online account world, the transactions costs
of switching are very low, and the evidence is that the response rate to small
interest rate differentials is rapid.

While there may be more repricing to come, it is worth mentioning that as part
of the Basel III liquidity standards, banks are required to demonstrate to
APRA that they have an appropriate liquidity transfer pricing model. APRA is
conducting a trial run of the new liquidity regime over the coming year and
one might expect these new liquidity pricing models to come into effect as
part of that. This will affect not just deposit pricing but pricing on the
other side of the balance sheet, namely loans, as well. It will have a particular
impact on contingent facilities such as lines of credit.

To return to the issue of HQLA for a minute. As most of you are aware, there
is a shortage of HQLA in Australia. The stock of government debt on issue,
both Commonwealth and state, is well short of the liquidity needs of the banking
system. Hence, as part of the liquidity regime, the Reserve Bank will be offering
banks access to a Committed Liquidity Facility (CLF). For a fee, the Reserve
Bank will make available sufficient liquidity (against eligible collateral)
to address the shortfall of HQLA beyond the banking system's holdings of
Commonwealth and state government debt. The motivation for doing so reflects
the societal gains that I talked about earlier from the banking system engaging
in an appropriate amount of maturity transformation. The pricing of the CLF
is aimed at replicating the cost of holding HQLA in the form of government
debt. That is, it is designed to be the same as the liquidity premium embedded
in government paper.

The fact that there is a cost to the banking system of holding HQLA, either
in the form of government debt or in the fee paid to have access to the CLF,
is in keeping with one of the main motivations of the Basel III liquidity regime,
namely that banks engage in the appropriate amount of maturity transformation.
Generally speaking, liquidity was underpriced prior to 2007 with the result
that excessive maturity transformation was undertaken, manifest in some cases
in highly unstable short-term funding structures. The new liquidity regulation
increases the cost of liquidity, but it is not designed to increase the cost
so much that insufficient maturity transformation is undertaken from society's
point of view.

Having talked about liquidity from the banking system's point of view, I
will finish with a few thoughts on liquidity in the superannuation (pension)
system. In many ways, liquidity issues in the super sector are very similar
to those in the banking sector. While the super sector generally thinks of
itself as being in the asset management business, it is obviously very much
in the intermediation business. It takes in savings and then invests them in
a wide array of assets.

Because of the portability of super accounts as well as the ability of superannuants
to change their asset allocation at relatively short notice, the super sector
is also in the business of maturity transformation. Some, potentially unknown,
share of its liabilities may be called on at short notice. But some of its
assets are long-dated and not easily liquefied at short notice, or if they
can be, only at fire-sale prices.

As with banks, society values the maturity transformation that the super sector
undertakes, particularly in terms of the funds it provides for longer-lived
projects. But as with the banking system, there is an optimal degree of maturity
transformation and an optimal amount of liquidity to be held. It is desirable
that super funds don't hold all their assets in highly liquid form for
the fear that all of its members may withdraw their funds all at once, just
as banks don't put all their assets in liquid form for the fear that a
bank run might occur. But at the same time, it is not desirable for all of
a super fund's assets to be invested in highly illiquid assets.

To some extent, the super sector's relatively large allocation to equities,
which are, in principle, easily liquefied, but relatively small allocation
to fixed income, which is not easily liquefied, may reflect some of these liquidity
considerations.

But at the heart of it, these liquidity management issues are very similar to
those facing a bank. I think many of the principles of liquidity management
translate from the banking sector to the super sector, although I have the
sense that this is not yet fully appreciated.

Endnote

See Debelle G (2013), ‘The Impact of Payments System and Prudential Reforms on the RBA's Provision of Liquidity’,
Address to the Australian Financial Markets Association and Reserve Bank
of Australia Briefing, Sydney, 16 August. Also see Stein J (2013),
‘Liquidity Regulation and Central Banking’, Speech at the ‘Finding
the Right Balance’ 2013 Credit Markets Symposium sponsored by the
Federal Reserve Bank of Richmond, Charlotte, North Carolina, 19 April.
Available at <http://www.federalreserve.gov/newsevents/speech/stein20130419a.htm>;
Coeuré B (2013), ‘Liquidity Regulation and Monetary Policy
Implementation – From Theory to Practice’, Speech at the Toulouse
School of Economics, Toulouse, 3 October. Available at <http://www.ecb.europa.eu/press/key/date/2013/html/sp131003.en.html>.
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